The GOP’s Payroll Tax Opportunity

James C. Capretta and Yuval Levin

December 10, 2012, Vol. 18, No. 13

Despite the outcome, Republican presidential nominee Mitt Romney did many things right during the course of this year’s campaign. Perhaps most notably, polls suggest that he was able to convince a plurality of Americans that the GOP’s plan for smaller government was better for promoting long-term economic growth than the president’s statist approach. But there was one line of attack Romney was never able to overcome, and which may well have cost him the working-class voters he needed to win: The Obama campaign effectively drove home the notion that Romney, and Republicans more generally, care more about the rich than the middle class.

There can be no doubt that answering that charge, by proving it wrong, will be essential to the GOP’s electoral future. That cannot mean adopting policies that Republicans don’t believe are right, but it must mean taking every opportunity to apply conservative principles for the benefit of working families, and showing voters why conservative ideas are better for everyone, emphatically including the middle class.

And yet, mere weeks after the election, we find congressional Republicans once again at risk of falling into the Democrats’ trap. The so-called fiscal cliff that is now riveting Washington’s attention involves the automatic application of the spending cuts agreed to in last year’s debt-ceiling talks combined with the expiration of several tax policies, which promises to increase the tax bills of many Americans. The two most significant tax increases result from the expiration of the Bush tax cuts (which would raise everyone’s income taxes) and the expiration of the payroll-tax holiday enacted in 2010 and renewed last year (which would raise everyone’s payroll taxes).

Republicans want to retain the Bush income tax rates for everyone, while Democrats want to retain them for Americans earning less than $200,000 (or $250,000 for couples). The dispute between them on that front, in other words, is about whether taxes will go up for upper-income households and many small businesses. It is a fight worth having, but both parties seem oddly complacent about the return of higher payroll-tax rates—which would hit far more Americans, and especially middle-class families.

For households squarely in the middle class, income taxes are less of a burden today than payroll taxes, because a variety of deductions, credits, and exclusions either exempt most of these households from any income tax liability at all, or leave them paying very little.

Not so with the Social Security and Medicare payroll taxes. Prior to 2011, the combined Social Security and Medicare payroll tax was 15.3 percent for households with incomes up to about $100,000, with half paid by the employer and half paid by the worker. For a family making $50,000 per year, that’s a tax liability of $7,650. According to the Tax Policy Center, households in the middle quintile of the income distribution pay an effective payroll-tax rate that is, on average, nearly three times what they pay in income taxes.

For these households, the 2 percent increase in the payroll tax that would result from a failure to renew today’s rates would be significant—a worker earning the median income would see his tax bill rise by $1,000 a year, which would be more than enough to make him take notice. The message for the GOP should be obvious: The party of low taxation must apply that broad principle not just to income taxes but to payroll taxes too.

And yet, rather than start a fight to prevent a middle-class tax increase, Republicans seem resigned to it, and may even leave an opening for the Democrats to oppose the increase while the GOP focuses exclusively on defending low rates for top earners.

This is not the first time Republicans have missed the opportunity to make the case for this middle-class tax cut. The idea of responding to our weak economy by lessening the tax burden on the middle class came first from conservatives. In 2009, as Democrats were preparing their pork-ridden stimulus bill, a few conservative economists—most notably Lawrence Lindsey (in these pages) and Douglas Holtz-Eakin—argued that Republicans should propose a significant reduction in the payroll tax as their alternative means of encouraging growth. Republicans never took the advice, and instead it was President Obama who seized that idea a year later.

In 2010, after the GOP’s midterm-election victory, the president proposed a one-year reduction in the Social Security payroll tax, taking the employee share of the tax from 6.2 percent to 4.2 percent (employers continue to pay 6.2 percent). Though reluctant, Republican leaders went along with the cut because it was combined with an extension of the Bush-era tax rates. In late 2011, the payroll-tax cut was extended for another year, through 2012.

Now, as the president and congressional leaders negotiate over how to steer clear of the tax hikes and spending cuts looming at the beginning of 2013, the future of the payroll tax is very much up in the air. A few Democrats (like Chris Van Hollen, on the House Budget Committee) have expressed support for extending the cut, but others (including House Democratic leader Nancy Pelosi) have expressed opposition, and the administration has been noncommittal. The opening is there for Republicans to become the champions of extending the cut, and thus the champions of all 155 million American wage earners whose tax burdens would be kept from rising—including millions of middle-class workers not much affected by the income tax debate.

So why the reluctance? A sizeable faction in the GOP is skeptical of the economic value of cutting payroll taxes, especially if it is only done temporarily. But this concern ignores some key facts about the current economic moment. For starters, all the grave worry about the “fiscal cliff” centers on the fact that it would involve too much fiscal consolidation too quickly. Most economists believe that the $600 billion in tax hikes and spending cuts scheduled to take place in 2013 would push the economy back into recession. The payroll tax is a key component of this problem. At $95 billion, the sudden jump in payroll taxes would be second only to expiration of the Bush-era tax rates in terms of the burden it would place on the American economy.

Moreover, conservatives have argued for years that one crucial key to improving long-term growth is reducing marginal tax rates as much as possible in order to avoid undermining not only the incentives to save and invest but also the incentives to hire and work. The payroll tax is a direct tax on employment and work. If it were lower, employers would have stronger incentives to hire, and workers would have greater incentives to work longer and earn more.

The primary criticism of extending the payroll-tax cut, however, is that it would undermine Social Security and weaken the incentives for fiscal discipline in the program. Social Security is effectively financed through payroll-tax receipts deposited into the Social Security Trust Funds. At moments (such as now) when the trust funds are projected soon to be depleted, the only remedy before Congress has been to scale back benefit commitments, increase revenue, or both. When the payroll tax was cut in 2011 and 2012, however, neither party wanted it to come at the expense of the trust funds. So the lost payroll-tax revenue was covered with direct payments from the general fund of the Treasury. This precedent has some in both parties worried.

Conservatives fret that the door has been opened to papering over Social Security’s long-term deficit with similar transfers from the Treasury in the future, thus reducing pressure for reform. Liberals, on the other hand, worry that introducing general-fund financing into Social Security will weaken political support for the program. Up until the past few years, the amount of money collected by the payroll tax was at least as great as the amount paid out in benefits by the program, thus creating the perception among workers that they had “earned” their benefits. If Social Security were partially financed out of the Treasury’s general fund, the program might begin to be viewed more like other government spending programs, including welfare.

Neither of these concerns should hold Republicans back from embracing an extension of the payroll-tax cut. The idea of earned benefits in Social Security was always a fiction. Today’s beneficiaries are not paid back money they put into the system but are paid with money that today’s workers pay in taxes. And money raised through the payroll tax is not put aside for Social Security. It is spent by the Treasury on other things in return for a formal commitment to pay benefits when they come due. The payroll tax is essentially used as a source of low-interest borrowing for the rest of the government, undermining fiscal discipline more than reinforcing it.

If the idea of a trust fund with its own balance sheet once served as an impetus for reform (as it surely did in the late 1970s and early ’80s), today it serves only to shield Social Security from the pressure for reform that results from the federal government’s overall fiscal imbalance (which is greater than that of the Social Security trust funds). It is the reason why Democrats can say (as White House press secretary Jay Carney did last week) that Social Security, which is the largest line item on the federal government’s badly imbalanced budget, “is not a driver of the deficit.”

Moreover, within Social Security, there are large transfers from high-wage to low-wage workers and from dual-income households to single-income households. There is no reason why these transfers should be obscured by the mythology that everything is “paid for” with payroll taxes.

Republicans should not allow themselves to fall into the position of insisting on high payroll taxes to finance the government’s irresponsible entitlement-spending commitments. That is terrible economics, and lousy politics too. Instead, payroll taxes should stay low to help struggling working families, without in any way jeopardizing benefits for current recipients. The program should come to be seen (as it has always in fact functioned) as part of the government’s overall budget, and therefore part of its budget problem, rather than being shielded from reform thanks to a misunderstanding of how the government uses the money it raises through a regressive tax that makes the lives of working families harder. In the coming years, entitlement reform is absolutely necessary, and for that purpose, too, a lower payroll-tax rate is far better than a higher one.

The fiscal cliff talks offer Republicans an opportunity to apply their low-tax, pro-growth principles to the plight of the middle class, and so to show voters that conservative ideas are at least as helpful to working families as to business owners and investors. And more important, they offer an opportunity to provide tax relief that would actually help spur the economy, and do so by helping some of those most in need of a break.